The Fed Should Consider a ‘Bad Bank’

Federal Reserve Chairman Ben Bernanke sees little risk of inflation because he doesn’t look in the right places. Inflation is a general increase in prices, but increases always occur at different rates. Right now, labor costs are not rising but other costs, such as the prices of raw materials, have been and are continuing to increase. Businesses will pass some of these costs to their customers. Health-care costs also are continuing to rise.

Mr. Bernanke tells us that inflation won’t be a problem as long as unemployment remains at an unacceptable level. But considerable research shows that this reasoning is badly flawed. During the inflation of the 1970s, for example, the discredited “Phillips Curve”—which suggested that high unemployment and rising prices shouldn’t go together—persistently underestimated inflation and misled the Fed into pursuing an ever more expansive policy. If the Fed looked, it would find many other countries that experienced high inflation and high unemployment together.

Those who doubt that the United States is headed for inflation remind us that increases in the consumer price index (CPI), and the “core” CPI that omits food and energy prices, remain modest. But the CPI and the core CPI are currently misleading because 40% of the CPI and 25% of the core CPI represent housing prices and are heavily dependent on statistical estimates of what homeowners would pay to rent their homes. Most of us never see these prices and do not pay them the same way we pay for food, gasoline and health insurance.

Furthermore, the Fed treats gasoline and oil price increases as a transitory blip. That’s almost certainly correct about the effect of Arab unrest or the Japanese tsunami. But much of the rise in oil prices came before these events and was in response to the strengthening world economy. Prices will likely continue to rise as the world economy grows. Meanwhile, world grain prices have been driven up by the foolish U.S. ethanol program. When ethanol raises corn prices, prices for substitutes like wheat and rice rise also. There is no sign that Congress will repeal the ethanol program.

When countries run huge budget deficits with rapid money growth and a depreciating exchange rate, inflation follows. There is no reason to believe we will escape the consequences.

The biggest risk is that the Fed will wait too long and be too hesitant to begin tightening. Fed policy discussions always concentrate on near-term data and events over which the Fed has little control. They give much less attention to longer-term events that a central bank can influence. There is a long lag, up to two years, from the beginning of anti-inflation policy to success. Much of the time lag reflects market beliefs that the Fed will not persist once unemployment rises. By the time the Fed finally decides inflation is coming, it will be here.

One of the Fed’s recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its “quantitative easing” policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way? One idea is for the Fed to create its own version of a “bad bank.” The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity. The long-term government debt and mortgage-backed securities would be the new bank’s assets. (The $1 trillion in Fed-created “excess” bank reserves as a result of quantitative easing would become the liabilities of the bad bank.)

The Fed would make a commitment not to sell any of the bad bank’s mortgage-backed securities and Treasurys until they mature. Almost half of the Fed’s currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery. As the mortgages mature and are paid off, the bad bank’s assets decline. The reduction in the bad bank’s assets means that its liabilities, the excess reserves, would also decline—though that would be years away. Letting the market know precisely when the mortgage-backed securities would be sold makes the adjustment to the future elimination of excess reserves manageable.

The Fed’s current operating balance sheet would be back to a more manageable range of about $1 trillion. This proposal removes some of the risk of inflation by removing some of the bank reserves that threaten to fuel it.